Why India should go for impactful inclusion to exclude less

If we want to see income growth in the country’s middle classes, shouldn’t we simply provide loans to all of our freshly minted college grads to start businesses?

The reasons for that not working are obvious. Most graduates wouldn’t have any idea what business to do. Some with ideas wouldn’t have the motivation, while others will fail.

And yet, there was a time when we believed that a loan could convert dormant labour into productive entrepreneurs. This assumed that the poor are far more entrepreneurial than the rest of us. Furthermore, it was perpetuated that this could be accomplished even at high interest rates, with the assumption that the poor are far superior in their abilities to generate high returns than the rest of us.

These assumptions were found to be illogical. Studies showed that only about 15 per cent cases saw income gains. The Malegam Committee study by the RBI showed that 75 per cent of the loans were spent for consumption.

Among the not-so-poor, from whom data is easier to get, only 7-15 per cent are entrepreneurs. The majority of those who do start businesses fail. Yet, no one argues that banks should stop lending to small businesses. Capital is integral to commerce, and failure is part of the package, the risks that we must take for the successes.

Should it surprise anyone that the poor are no different? If anything, with poor education and lack of access to other resources, the challenge is greater, failure even more likely. So, has giving out loans to the poor been a failure with respect to social impact? It has not.

There is no magic bullet that will ‘solve poverty’. Rather, the agenda of progress begins with inclusion of populations into supply chains that enable efficient flow of goods and services to and from communities otherwise disconnected from the modern economy.

When microfinance first began, it was catering to people who had no identity. The innovation was the idea of group lending. Where identity was not verifiable, local peer pressure kicked in to ensure repayment and to mitigate risk. Past efforts by government mandate to lend to these undocumented individuals had resulted in defaults of 40 per cent and higher.

But repayment in this group model was successful. It made possible to lend to these undocumented communities at a larger scale. It was the first step in inclusion.

But it was not enough. One person could be a part of multiple borrower groups. Or the same group could borrow from multiple lenders. Without a way to authenticate identity, this was arecipe for disaster.

The crisis, however, did a great deal for the industry. Banks lending to microfinance institutions demanded that each member provide some form of identification or KYC. This sent potential borrowers rushing to get some form of identification. The industry then created a self-regulatory body that instituted a credit bureau. This was the second step in inclusion.

Next, there is the question of cost. Microfinance interest rates are much higher than the rates large corporations pay. That’s because the cost of delivery is much higher in this high-touch, poorly connected paradigm. In a selfsustaining operation not subsidised by grants, this cost is borne by the borrower in the form of interest.

With government regulation capping interest rates and spreads in the industry, it has led to a scramble for process efficiencies that control costs: ways for loan officers to be faster and more effective at capturing information about the borrower, and back-end processes to turn around loan decisions more efficiently. Some gains have come from economies of scale.

But much has come from external factors such as the falling costs of smartphones and tablets. With these, costs of delivery have fallen steadily, as have interest rates. Yet another step in the agenda of inclusion. Finally, there’s the challenge of value —of how to direct capital more productively. This requires a due diligence into the occupations and business activities of potential borrowers, none of which is recorded in any official way.

To take on a diligence that goes beyond self-report would be prohibitive, not just in terms of cost but even its very possibility. The industry must find more clever ways to take on this ‘dark data’.

This is the next challenge of inclusion that must be tackled to provide more tailored products. The process of impactful inclusion is an evolution of moving parts that slowly but surely connects more people efficiently to the bloodlines of the formal economy. Even for microfinance, it is not the end of the road but only the beginning.